What it means
A venture capitalist normally invests in promising young companies in return for a share of ownership, and wants the business to succeed. A vulture capitalist is accused of doing the opposite, waiting until a company is short of cash and then offering a rescue on terms that favour the investor heavily.
The founders, with few alternatives, may feel they have no choice but to accept. Typical features of such deals include a very low company valuation, so the investor gets a big share for a small cheque.
They often include liquidation preferences (the right to be paid back first if the company is sold), strong anti-dilution rights and board control. Some include provisions that wipe out the founders' stake if targets are missed.
The label is not neutral and not every tough investor deserves it. A company that is genuinely close to failure may be worth very little, and an investor taking on that risk may reasonably ask for strong protections.
The difference lies in whether the terms are a fair price for the risk or an exploitation of desperation. Founders can protect themselves by keeping enough cash for several months, raising money before the situation becomes urgent and building relationships with several investors.
A competing offer is the best defence, since it changes the balance of power. Taking independent legal advice is essential.
For employees, customers and suppliers, a change of control in a distressed company can mean cost cutting, new management or a sale. The business may survive because of the rescue funding, but the original vision may change.
The term applies more broadly to investors who profit from other people's distress, including some buyers of troubled debt. Whether the label is deserved depends on the terms and the outcome for the company.
In practice
Real-world examples.
Example
A software founder has three weeks of cash left when an investor offers $1,500,000 for 60% of the company. The founder compares the offer with the failure of the business and accepts, but later learns that a bridge loan from existing investors would have been available at a better price.
Example
A health-technology start-up in difficulty receives a rescue offer that includes a liquidation preference of three times the money invested. The board's lawyer calculates that at any sale price below $6,000,000 the founders would receive nothing. They negotiate it down to a one-times preference.
Example
A manufacturing firm's lender sells its distressed loan at a discount to an investor, who then uses the debt to take control of the business. Some commentators call this vulture investing, while others argue it keeps the company operating.
Formula
Calculation
Investor ownership = Investment / Post-money valuation
Post-money valuation = Pre-money valuation + Investment
A start-up needs $2,000,000 to survive. Under a fair earlier valuation of $10,000,000 before the money, the post-money value would be $12,000,000 and the investor would own $2,000,000 / $12,000,000 = 16.7%. A distressed investor offers a pre-money valuation of only $4,000,000, so post-money is $6,000,000 and the investor owns $2,000,000 / $6,000,000 = 33.3%. The same cheque buys twice the share, and the founders' stake falls sharply.Case study
Seen in the real world.
Kestrelbrook Labs is an illustrative, fictional start-up that ran out of money after a product delay, with only six weeks of cash left. Its founders had been negotiating with a fund that valued the company at $12,000,000 before the delay.
When the delay became known, the fund reduced its offer to a $3,000,000 pre-money valuation for a $2,000,000 investment, giving it 40% ownership, plus a board majority and a two-times liquidation preference. The founders were angry but had no other term sheet.
A friend introduced them to a second investor, and the competing interest led the first fund to improve its offer to a $5,000,000 pre-money valuation with no board majority. The fictional founders learned that time and alternatives are their strongest protection, and they now keep at least nine months of cash.
Watch out
Common mistakes.
- Accepting the first rescue offer without seeking alternatives, which hands the investor full negotiating power.
- Focusing only on valuation and ignoring terms such as liquidation preferences, board control and anti-dilution rights.
- Labelling every tough investor as a vulture, when strong terms can be a fair price for the real risk of backing a failing business.
Questions
People also ask.
Is the term a formal category of investor?
No, it is an informal and critical nickname with no legal definition.
How can founders avoid such deals?
They can raise funds early, keep several months of cash, build relationships with multiple investors and take legal advice before signing.
What is a down round?
It is a funding round at a lower valuation than before, and it often happens when a company is in difficulty.
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